Friday, October 10

EVA revisited

Economic value Added

Economic Value Added™ is the financial performance measure that comes closer than any other to capturing the true economic profit of an enterprise. EVA also is the performance measure most directly linked to the creation of shareholder wealth over time.

EVA = Net operating Profit After tax – (Capital Employed x Cost of Capital)

Net Operating Profit After Tax (NOPAT): A company's potential cash earnings if its capitalization were unleveraged (that is, if it had no debt). NOPAT is frequently used in economic value added (EVA) calculations.
Calculated as:
NOPAT = Operating Income x (1 - Tax Rate)

Put most simply, EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. As such, EVA is an estimate of true "economic" profit, or the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and lenders could get by investing in other securities of comparable risk.

Profits the way shareholders count them
The capital charge is the most distinctive and important aspect of EVA. Under conventional accounting, most companies appear profitable but many in fact are not. As Peter Drucker put the matter in a Harvard Business Review article, "Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources…Until then it does not create wealth; it destroys it." EVA corrects this error by explicitly recognizing that when managers employ capital they must pay for it, just as if it were a wage.
By taking all capital costs into account, including the cost of equity, EVA shows the cash wealth a business has created or destroyed in each reporting period. In other words, EVA is profit the way shareholders define it. If the shareholders expect, say, a 10% return on their investment, they "make money" only to the extent that their share of after-tax operating profits exceeds 10% of equity capital. Everything before that is just building up to the minimum acceptable compensation for investing in a risky enterprise.

Aligning decisions with shareholder wealth
EVA has been developed to help managers incorporate two basic principles of finance into their decision making. The first is that the primary financial objective of any company should be to maximize the wealth of its shareholders. The second is that the value of a company depends on the extent to which investors expect future profits to exceed or fall short of the cost of capital. By definition, a sustained increase in EVA will bring an increase in the market value of a company. This approach has proved effective in virtually all types of organizations, from emerging growth companies to turnarounds. This is because the level of EVA isn't what really matters. Current performance already is reflected in share prices. It is the continuous improvement in EVA that brings continuous increases in shareholder wealth.

A financial measure line managers understand
EVA has the advantage of being conceptually simple and easy to explain to non-financial managers, since it starts with familiar operating profits and simply deducts a charge for the capital invested in the company as a whole, in a business unit, or even in a single plant, office or assembly line. By assessing a charge for using capital, EVA makes managers care about managing assets as well as income, and helps them properly assess the tradeoffs between the two. This broader, more complete view of the economics of a business can make dramatic differences.

Ending the confusion of multiple goals
Most companies use a numbing array of measures to express financial goals and objectives. Strategic plans often are based on growth in revenues or market share. Companies may evaluate individual products or lines of business on the basis of gross margins or cash flow. Business units may be evaluated in terms of return on assets or against a budgeted profit level. Finance departments usually analyze capital investments in terms of net present value, but weigh prospective acquisitions against the likely contribution to earnings growth. And bonuses for line managers and business-unit heads typically are negotiated annually and are based on a profit plan. The result of the inconsistent standards, goals, and terminology usually is incohesive planning, operating strategy, and decision making.

EVA compared with MVA
Unlike Market based measurements like MVA[Market Value Added is the difference between the equity market valuation of a listed company and the sum of the adjusted book value of debt and equity invested in the company. In other words, it is the sum of all capital claims held against the company; the market value of debt and the market value of equity], EVA can be calculated for a divisional (strategic Business Unit) level. Unlike equities measurements, EVA is a flow and can be used for performance evaluation over time.

EVA compared with EBIT and EPS
Unlike accounting profit such as EBIT, PAT and EPS, EVA is economic and is based on the idea that a company must cover both the operating costs and capital costs.

Usage of EVA:
EVA can be used for the following purposes:
Ø Setting organizational goals
Ø Performance measurement
Ø Determing bonuses
Ø Communication with shareholders and investors
Ø Motivation of managers
Ø Capital budgeting
Ø Corporate valuation
Ø Analyzing equity securities.


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